The Different Ways that Friends and Family Can Provide the Capital They Promised - Essay Example

LATROBE UNIVERSITY SCHOOL OF LAW LL.M. Global Business Law LAW5UCF – Corporate Finance for Lawyers Prof. Jennifer A. Quaid Student Name: (a) Advise Sara on the different ways that her friends and family can provide her the capital they promised. Through loans or investment. Explain the consequences of each way of providing capital, both from the perspective of PP Inc and its shareholders and those who provide the capital. What do you recommend in light of her circumstances? For a start-up company like Sara’s, there are two ways to finance its operations - one is by debt financing and the other is by equity financing (Boots, 1991). Debt financing requires debts to raise capital. Equity financing on the other hand is raising capital by selling shares of stocks to the public. Debt financing is a very good option to raise capital when the business has the capability to pay the debts on the terms detailed by the contract of agreement. Businesses that raise capital through debt can retain its ownership of the company and can make independent strategic decisions that the company needs to do to survive (Audretsch & Lehmann, 2004). Moreover, debt financing is easy to avail because most banks – local and international – are attracted to small and medium enterprises. The major drawbacks of debt financing, however, includes paying high interest rates for the debt and conforming to the terms of payment as desired by the creditor with a possibility of little or no grace period for the first payment. This implies that Sara’s company, PP Inc, needs to be able to immediately generate cash in order to pay for its debts and interest rates which under the present circumstances is quite impossible to achieve. Equity financing on the other hand allows start up companies to get funds by sharing part of its ownership (of the business) to the public. Equity financing is usually done through initial public offerings (IPO) or through capital financing schemes targeting selected individuals. Businesses opting for capital financing do not need to worry about grace periods or interest rates as they can use the funds they get in whatever way for the business as long as they are able to satisfy the financial goals of the stockholders (Audretsch & Lehmann, 2004). With the need for capital reaching the general market, Sara would no longer need to worry if her friends could not raise the amount she needs as the volume of investors in the market looking for new investment opportunities is high. The main issue with equity financing, however, is the need for the owner of the up company to yield to the opinions and decisions of the stockholders because ownership is bought in exchange for the required funds. Relating to the case, Sara’s friends and families can either lend her the money she needs (debt financing) or they can either demand ownership of the business by asking for stock options in exchange for the funds they would provide (equity financing). Having Sara’s friends and family invest on stock options may not be a wise move. Stock ownership translates to voting rights which implies that stock holders can choose to vote on issues that concerns the growth of their stocks’ values. But because Sara needs to be in control of the decisions and she would most likely need all the independence she can get in order to succeed with her plans for the business, it would be very appropriate for her to veer away from equity financing and opt instead to the debt financing. However, her friends and family may feel reluctant to lend their money to Sara, particularly on her ability to pay for her debts knowing that Sara has no other source of income but the business. Her family and friends may run the risk of not getting paid for what they lend her which may ruin good relationships. (b) Sara is discouraged but she does not want to give up yet. After consulting with Bob and Ami, they all agree that there is no choice but for PP Inc to approach an arm’s length sources of funds. They are apprehensive about what is involved. Advise Sara, Bob and Ami as to what types of information potential investors will expect from PP Inc before providing any capital. Generally speaking, potential investors are attracted to investments that (a) offer quick profits in the short run or (b) stable cash inflow on the long run. Majority of the investors understand the need of start up (or expanding) businesses for capitalization so they don’t get very particular with how much funds were initially needed. However, these investors want some assurance from business owners that their investments would see some growths within a specific period. For this reason, potential investors would want to see the business plan and the cash flow projections of the business. The business plan is the blue print of the business. All the information contained in the business plan can be classified into three categories: operations, timeline, and product line. Operations refer to all the activities of the business starting with the administrative, accounting, and management functions to the marketing, sales, production, and manufacturing of goods and services including facilities maintenance and human resource. The business plan defines how the business will be able to perform these major operational functions of the organization and at the same time define how each and every department will work together to achieve the purpose of the business. Timeline is the part of the business plan that provides details on the timeline of what the business aims to achieve. The timeline serves as the guide for the business in determining whether the things they want to achieve would fall in place in a given period. Timelines also serve as the deadlines for businesses to achieve or perform the tasks they have set for themselves. Progress and stability can be determined by checking what the organization has achieved for a given period vis-à-vis its timeline. Lastly, business plans contains the profit-generating activities of the organization, particularly how products or services are to be manufactured or perfected. From an investor’s point of view, the business plan is an excellent avenue to learn more about an establishing company. Most investors do not have any idea of what or how the business will be using the funds it owes. Through the business plan, investors can have a pretty good idea of how the business will operate, what are the functions of individuals and organizations in the business, and can estimate the growth of the business in a given period which also translates to the growth of their investments. The projected cash flow statement provides information on the cash flow of the business in a given time frame, including the possible sources of income and possible expenses. Investors can gain a good idea about how the business will grow and prosper financially when they have access to this information and so can make good and deliberate decisions whether or not to lend money to the business. Other types of information investors would like to see from the business are the articles of incorporation, management structure/management profile, financial ratios (whenever applicable), legal disclosures, and the business’ Mission, Vision, Goals, and Objectives (MVGO) for the information contained in these documents could allow potential investors to glean on the potential of the business over time. (c) CO is willing to be a passive investor in the business and leave the scientific and strategic decisions to management and the board. However they want the ability to increase their investment if things go well. Sara, Bob and Ami are uneasy about this. They ask you to explain how this could be done what the consequences would be for PP Inc. Explain all possible approaches for structuring Confederation Oil’s passive investment. Attracting potential investors has become a necessity for PPI since it has decided that it would have to invest on more sophisticated production equipments that could have a potentially high positive impact to the development of its business strategy. However, the management of PPI as well as its major shareholders need as much independence from external elements, particularly the potential investors, in order to achieve its goals. This independence prompts the management of PPI to look for passive investors who would invest funds to the company and wait in the sideline for long-term results. Commonwealth Oil (CO) could have been an excellent passive investor if not for the company’s desire to increase its investments in PPI if things will go smoothly, which makes the owners of PPI uncomfortable. CO’s demand to increase its share of the company in the future will threaten the decision-making process of the existing management of PPI in the long run, making them practically a subsidiary of the wealthier company. In order to avoid these conflicting views of both parties with regards to the long-term implications of the demands of CO, the management of PPI can outline the scope and limitation of the participation of CO in the company as well as the obligation of the company towards Commonwealth Oil in an indenture (or legal contract). An indenture is a legal contract issued by the issuer of bonds to the bondholder. Indentures outline the duties and responsibilities of the issuer of bonds to the bondholder including the time period of repayment, the amount of interest that will be paid, and whether the bond is callable or convertible after a given period among other things. This document also outlines the rights of the bondholders, giving specific details to how the bondholders can exercise their rights as well as the scope of their rights and privileges in the issuing firm. An indenture becomes official when all the parties involved agreed on the terms and conditions laid out in this document and signatures are provided. Once legally binding, all parties involved are bound by the terms and conditions of the indenture and any violation to the provisions thereof can constitute a criminal liability. PPI can take full advantage of the features of the indenture, particularly the outlining of the responsibilities, rights, duties, and obligations of its investors. PPI can set the scope and limitations of the legal rights and privileges of its investors as well as define the extent of the company’s duties and responsibilities towards potential investors. PPI can enter into a bargaining agreement with any potential investor and convince these investors in agreeing to the terms and conditions of investment of the company. This implies that PPI can legally exert control over the extent of rights, privileges, and participation of its investors in the company. This further implies that PPI can define the limits of its independence and haggle with potential investors this position. In the case of Commonwealth Oil, PPI owners just need to negotiate with CO the non-negotiable terms and conditions contained in its indentures and have the potential investor agree to the limitations set by the company. However, this negotiation does not come without a price. Potential investors like Commonwealth Oil may get turned off to the possibility that the volume of its investment in PPI has a less chance of increasing in the long run. Moreover, this may translate to potential investors not wanting to invest to the business anymore because of the perceived constraints. As a result, PPI may find it hard to enlist big companies with similar goals to CO to invest for the firm. Nonetheless, PPI can resolve this potential disaster by offering incentives other than the increase in the volume of investment for the company. These incentives include interest rates that are higher than the market, voting rights, and access to information relevant to strategic management and technical decisions among other things. With these alternative incentives to divert thoughts on gaining more ownership of the company, passive investors like Commonwealth Oil may be persuaded to invest in PPI for strong and good reasons. (d) Sara, Bob and Ami are intrigued by this expression of interest from GES Inc and want to know more. Explain to Sara, Bob and Ami the different methods by which PP Inc and GES Inc might be combined. Be sure to outline for them the advantages and disadvantages of each method. What method do you recommend them to pursue with GES Inc? Working together with other businesses that offer similar products, process, or services can be a strategic step for PPI. This is because such action provides mutual benefits for both parties involve which can include cheaper production cost, bigger manpower, access to new and related technologies, and most importantly a possible increase in productivity and workplace efficiency. There are two major ways to combine Poop Power Inc (PPI) with Green Earth Solutions, Inc (GES Inc) – through an acquisition or through a merger. Mergers and acquisitions are strategic steps performed by companies to increase market share, lower production cost, increase productivity and efficiency, and establish stronger or more stable lead against competition. Mergers are the combination of two or more business entities under one wing (or one name) operating dependently, interdependently, or co-dependently from each other for the same goals and purposes (McDonnell, 2006). Businesses merge with other businesses because such options increases their bargaining power, efficiency in terms of machineries, manpower, and equipments, or such move offers both parties better perspectives for their operations or administrations. The most common reasons why businesses merge are to establish strategic position, increase operational capabilities, and diversify function and increase profitability. In some cases, business mergers are done in order to save one company from losing its business. In order to establish the importance of these factors, merging or acquiring companies go in great length to investigate the financial soundness of the business decision in order to make a decision about the matter. Plant equipments are audited, balance sheets are For example, UJF acquired Mitsubishi Tokyo Financials in order to expand the scope of its operations and intensify its profit-generating campaigns. UJF did an intensive investigation on the balance sheet of MTF and has studied the profit-generating activities of the other company before it made the decision to acquire the later. More importantly, UJF studied how it will place all the resources MTF has to its advantage and how it can better position itself in the market with the decision (Satwah, 2006). Unlike mergers whose identities of the involved companies remain intact, acquisitions require takeover of the identity of one party to be wholly integrated to the identity of the acquiring company. Acquisitions are the takeover or buy-out of majority of the shares or ownership of the target company to assume control. Acquisitions are typically done to increase the strategic position of the acquiring firm whereas buy-outs are pursued instead of expanding the business line and establishing the niche. One of the most famous corporate takeovers is the buy-out of Procter and Gamble of Gillette. With this buy-out, Gillette’s market share is given up to Procter and Gamble which further increased the market dominance of the acquiring company. In a way, this move of Procter and Gamble is strategic because it ensures the longevity of the company by slowly eliminating its competitors in smaller market segments. The main disadvantages of mergers and acquisitions include (a) conflict between cultures of the merging (or acquiring) businesses; (b) redundancy of work function which often translates to job loss; (c) conflict of objectives between organization which may lead to inefficiency and un-productivity in the workplace and (d) increase in the unit cost due to higher expenses during the merging process (Gitto, 2007). Given these choices, it is highly strategic for Poop Power Inc (PPI) to merge with Green Earth Solutions, Inc (GEI Inc) rather than let the later acquire it through a takeover of shares of ownerships. Merging business processes with GEI will present PPI a better avenue for growth and technological advancement. Because the technology GEI uses is very similar to the technology that must be used by PPI, the later can come into agreement with GEI for access of technology, manpower, and even credit line in exchange for what GEI would need from PPI (which will consist mainly of the waste product of PPI’s initial cleaning process). Consequently, such move would also decrease the expenses of GEI related to logistics and supply of raw materials for its processed biological fuel. (e) Assuming that PP Inc is not in default of any of its obligations under the loan agreement, explain to Uncle Bob, Sara and Ami how this clause affects the deal with GES, Inc. Can the deal still go forward? Breach of contract is a serious offense and the legal implications are enormous. Parties in a legally binding contract need to be able to perform their duty and responsibilities as stated in the contract to avoid any form of breach of contract. Otherwise, lawsuits are highly likely to occur. In this regard, it is necessary to evaluate the content and the context of the legal agreement PPI has had with OBIB. Section 8 of the loan agreement allows PPI, with certain restrictions, to merge or be acquired with a new business entity. The contract is made with a pretext that the entity with which OBIB has entered in agreement with will fulfil its legal obligations as stated in the contract. It allows mergers and acquisitions of the other party provided that there is a continuation of ownership of the company by the corporation or the person which OBIB has made the agreement with. With the plan of PPI to be totally acquired by GES Inc, taking in Sara as a Chief Researcher and paying off the shareholders with a handsome amount, the ownership of the business is transferred wholly to the acquiring business which may constitute a breach in the contract. However, the strategic decision of the acquiring company to hire Sara to run the research on the business implies that Sara is no longer the owner of the business and is now merely an employee. Furthermore, there is no expressed statement in the given scenario that implies that GES will take-over the obligations of the existing company as well which includes PPI’s loan with OBIB. The serious case of breach of contract can be avoided by Sara and PPI if it can provide another legal document that indicates that the new management of PPI is willing to take over the existing financial obligation of the company. Otherwise, such strategic decision may prompt legal actions from the part of OBIB. (f) Explain to Sara the differences between a publicly held company and a privately held company. Identify any particular things that Sara should be aware of as a potential member of the management team of GES, Inc. Publicly held companies are companies whose stocks are owned by many investors or by the public. Privately held companies on the other hand are owned by a relatively few individuals. Publicly held companies have easy access to investors’ funds compared to privately held companies because of their greater exposure in the market through their enlistment in the stock exchange market. Public companies are required to disclose financial and strategic information to the market whereas such disclosures are optional to privately held companies. Because of the limited disclosures of privately held companies, managements of the competition could have serious difficulties with their strategic plans and implementations because of the lack of information available on the competition. From a manager’s perspective, the potential difficulty that can be encountered in a privately held company is the lack of or absence of disclosure from the competition. Because privately held companies are not required to divulge information on the company’s performance or financial status, there would be no way for the competitor to know how to take into consideration the threats or opportunities in the market. This implies that Sara may find it hard to benchmark processes or check whether her management decisions are the right ones simply because there is nothing to compare these with. Consequently, Sara can use the same argument to move her research forward without the fear of having the competition copying or modifying her process, products, or research. (g) Explain to Sara what an option is and why GES has offered options to her in connection with her employment A stock option is a contract that gives the buyer the right, but not the obligation, to buy or sell the asset for a specific price at a certain date (Investopedia, 2010). Giving employees stock options is a form of financial incentive to the employees. Providing stock options to the employees is one of the many ways management of companies encourage active participation of the employees towards the success of the business. By giving the employees stock options with a resale value at a given period (which is typically higher than the current value of the stock), the employee will be theoretically motivated to help the company increase the value of its stocks up to the desired level. (h) Based on the information above and the financial statement of GES, Inc. (see pages 7-9), give Sara both an assessment of the Company from an equity holder’s perspective and an indication of how valuable the options offered to her might be now and in the future. Support your analysis with appropriate financial calculations. There is a growth trend in the 3-year financial performance of GES Inc. The financial statements show that for the last three years, GES is able to maintain profitability and a gradually sloping sales performance indicating that the firm has bigger potential for growth in the future. Sales have continually been growing in the last three years and the increase in the cost of goods sold is kept at minimum and in proportion to the growth in sales. GES has maintained a low liability profile by keeping its liabilities from growing significantly for the last three years, maintaining the long-term debts whenever necessary. The financial report also indicates that the company’s retained earnings have increased in 2009 compared to its retained earnings in the previous years. This indicates a sound financial health for GES. In other words, GES is in the financial position to acquire PPI and grow or develop the business from such a move. Financial ratio analysis indicates that GES is highly solvent which is a good indicator of its performance particularly during any unexpected market downturns. With a current ratio of 3.9 and a quick ratio of 1.87, the company can be able to pay its short-term debt without breaking a sweat. This further implies that Sara is in a company that is highly liquid and can finance its research department which means an even better strategic position for Sara within the company. ROA 0.164234 ROE 1.225 Analysis on returns of assets and returns on equity suggests that GES has not yet fully utilized its asset to bring more profits for the company with only 0.16 as its value for ROA. Similarly, for every dollar invested on the company, the company can only be able to grow the investment by 122% which is fairly small for a relatively promising company with a very promising product. Trend analysis would show that it is highly likely for GES to become more profitable if it integrate PPI’s products and processes into its existing processes as the expenses associated with the supply can be significantly reduced (after the acquisition of PPI). If the trend would continue in the next five years, it is highly likely that the strike value of the stock option ($7) will be negligible compared to the possible value of the stock by the end of the five year period. However, if GES would not be able to move forward or would receive a stalemate position in the next 5 years, the $7 stock option offered to Sara would still be negligible because of the very low volume offered to her (30 stocks). Q11 Advise the Board. Can it proceed with the transaction? Explain why or why not. The only applicable law in this case is the Supreme Court of Canada decision in BCE where the Supreme Court argued that in order for the debenture holder’s claims to become valid, it should prove section 192 of the Canada Business Corporations Act which states that 1. The statutory procedures have been met, (2) The application has been put forward in good faith and, (3) the arrangement is fair and reasonable” (Lang Michener LLP 2009). Number three has other specifications which are: (a) “The arrangement has a valid business purpose and (b) The objections of those whose legal rights are being arranged are being resolved in a fair and balanced way” (Lang Michener LLP 2009). This means that the transaction between GES and Swivels can push through except if the conditions set out in Section 192 of the Canada Business Corporations Act. GES is in a very good position to accept the offer of Swivels for three main reasons: first, the stockholders of GES will earn a handsome amount from the transaction which they can use to pursue other investments. Investors always look for better returns and such an offer is very hard to ignore. The very insignificant performance of GES in the market is probably due to the lack of demand, unavailability of equipments, or the lack of the right technology to pursue more profitable undertakings which resulted in a slack in its performance; second, the capability of GES to outperform the market is nil because of the lack of capitalization (or the inability to produce capital funds) to finance strategic and aggressive development plans for the company. Lack of funds translates to the absence of products or marketing campaigns which translates to profit loss; third and probably the most important of all, GES is not yet ready for the market. Even through the firm has been operating for many years now, it is yet to discover a good supply chain and distribution channels which it, due to its size and lack of capitalization, could not pursue. Hence, it would be for the benefit of the firm to take the offer and profit from it. Moreover, the opinion provided by the independent financial institution affirms the legality of such decision. GES would only need to negotiate the terms of its existing obligations to the acquiring company in order to avoid legal issues on the contracts it has made with various stakeholders. If GES can be able to transfer all obligations to the acquiring company, then GES is good to go. The industry where GES belongs is growing and is gradually gaining reputation in the market. This means that GES would lose the opportunity to achieve greater financial success in the long run if it gives up its ownership of the company and its promises. Hence, it is advisable that the management of GES reconsider its options beyond the legal issues in order for it to come up with a more detailed, comprehensive, and the best solutions possible knowing that it is in the position to grow even further in the long term if it could look for the right source of capital. References Audretsch, D & Lehmann, E. (2004). Financial High-Tech Growth. The Role of Debt or Equity. Papers on Entrepreneurship, Growth, and Public Policy. 2004-19. Max Planck Institute of Economics, Entrepreneurship, Growth and Public Policy Group Boot, Arnoud W A & Thakor, Anjan V & Udell, Gregory F, 1991. Secured Lending and Default Risk: Equilibrium Analysis, Policy Implications, and Empirical Results. Economic Journal. Royal Economic Society. 101 (406); 458-472 Gitto, J. (2007). Pros and Cons of Reverse Mergers: When is it the Right Choice. New Jersey Tech News. Retrieved online from http://www.gellerco.com/docs/Prosconsofreversemergers.pdf Investopedia. (2010). Options: Basics. Retrieved online http://www.investopedia.com/university/options/option.asp Lang Michener LLP. The Supreme Court of Canada’s BCE Inc. Decision: Essential Advice for Directors, Creditors and Commercial Litigators. Publication. Published on February 24, 2009. Retrieved on 12th Feb, 2010 from: http://www.langmichener.ca/index.cfm?fuseaction=content.contentDetail&ID=10468&tID=244 McDonnell, C. (June 2006). The technology factor in M&A and why you need IT due diligence. Dublin: Accountancy Ireland, 39(3), 40-41.  Satwah, B. (Oct1.2006). Special supplement: Service-oriented architecture- A tool for M&A success- A Mergers and acquisitions situation is an ideal one for SOA. London: The Banker, Oct1, 2006,1.  Read More